Brazil to Cut 25 bp As Policy Mix Worsens

new brazilBrazil’s COPOM is expected to cut 25 bp this week.  Fiscal policy remains a problem, as pension reforms are dead in the water ahead of October elections.  We think the fiscal and monetary policy mix is becoming more problematic.

POLITICAL OUTLOOK

An appeals court upheld former President Lula’s conviction on corruption charges and extended his sentence to 12 years.  While an appeal to the Supreme Court is possible, it seems increasingly unlikely that Lula will be able to run again for president.  Nevertheless, he has already accepted his PT party’s nomination even though formal registration isn’t until August 15.

National elections will be held in October.  Polls have Lula currently leading the field, despite his legal woes.  Latest Datafolha poll shows Lula with 37% support.  Excluding Lula, rightist lawmaker Jair Bolsonaro is leading with 18% support.  Leftist candidates Marina Silva and Ciro Gomes are polling 13% and 10%, respectively.  They are closely followed by centrist candidates Gerardo Alckmin and Luciano Huck with 8% support each.

President Temer has been in office since Rousseff was impeached in 2016.  He was never planning to run for election this year, and so he was willing to push for unpopular reforms.  Recent comments suggest he has reached the end of his rope with regards to pension reform, as stiff resistance is being seen from Congress.

Indeed, support for pension reform has fallen.  Congress just returned from recess, and it appears that support has fallen to 240-250 lawmakers in favor of the reforms.  That number stood near 270 at the end of the year, but still short of the 308 needed to pass.  Some more changes to the text may be made, but many lawmakers do not believe it will make much difference in the voting.

Brazil scores poorly in the World Bank’s Ease of Doing Business rankings (125 out of 190).  The best components are protecting minority investors and getting electricity, while the worst are starting a business and paying taxes.  Brazil does slightly better in Transparency International’s Corruption Perceptions Index (79 out of 176 and tied with Belarus, China, and India).

ECONOMIC OUTLOOK

The economy is finally picking up from the deep recession.  GDP growth is forecast by the IMF to accelerate modestly to 1.9% in 2018 from an estimated 0.7% in 2017, before picking up to 2.1% in 2019.  GDP rose 1.4% y/y in Q3, the strongest rate since Q1 2014.  Monthly data so far in Q4 suggest growth near 3% y/y and highlights upside risks to the growth forecasts.

Price pressures bear watching, with IPCA consumer inflation accelerating to 3.02% y/y in mid-January from 2.95% in December.  IPCA data for all of January is due out Thursday and is expected to rise 2.99% y/y.  If so, it would still be in the bottom half of the 2.5-6.5% target range.  PPI inflation has been accelerating, however, and other measures suggest price pressures are rising.

All this supports the case for steady rates, yet COPOM has signaled more easing was likely. As such, markets have priced in a final 25 bp cut to 6.75% this Wednesday.  Incredibly, markets are pricing in the first hike as early as Q3.  Monetary policy typically runs with lags of up to a year and so we find it dangerous for COPOM to be cutting rates right into the potential start of a tightening cycle.

Fiscal policy remains an issue as pension reforms stall.  These reforms were initially meant to save BRL750-800 bln over ten years, but the government has cut those projections by nearly half.  If passage is not seen, these costs will remain a bigger drag on the fiscal accounts.  The nominal budget deficit came in at around -8% of GDP in 2017, down from -9% 2016.  The gap is expected to remain around -8% of GDP in 2018 before narrowing to -7% in 2019, but the trajectory will depend on fiscal reforms under the next administration.

The external accounts should worsen modestly.  Over the past couple of years, low commodity prices hurt exports while the sluggish economy helped reduce imports.  Those trends have now reversed.  The current account deficit was an estimated -1.4% of GDP in 2017, and is expected by the IMF to widen to -1.8% in 2018.  However, the wider gap will still likely be covered entirely by FDI inflows.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At $384 bln in January, they cover nearly 17 months of import and are over 8 times larger than the stock of short-term external debt.  Thus, external vulnerabilities remain relatively low.

INVESTMENT OUTLOOK

The real has done OK after underperforming in 2017.  In 2017, BRL fell -2% vs. USD and was ahead of only the worst performers ARS (-14.5%) and TRY (-7%).  So far in 2018, BRL is +2% YTD and is in the middle of the EM pack.  The best performers YTD are MXN (+5.5%) and COP (+5%) while the worst are ARS (-4.5%) and PHP (-3%).  Our EM FX model shows the real to have STRONG fundamentals, so it should start to outperform more.

Brazilian equities are outperforming EM after underperforming in 2017.  In 2017, MSCI Brazil rose 21% vs. 34% for MSCI EM.  So far this year, MSCI Brazil is up 11% YTD and compares to 5% YTD for MSCI EM.  This outperformance should ebb, as our EM Equity model has Brazil at a VERY UNDERWEIGHT position.

Brazilian bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -40 bp YTD.  This is behind only Peru (-47 bp) and ahead of the next best performers Russia (-29 bp) and Argentina (-9 bp).  With inflation likely to continue rising and the central bank potentially tightening later this year, we think Brazilian bonds will start underperforming more.

Our own sovereign ratings model showed Brazil’s implied rating steady at BB+/Ba1/BB+.  Actual BB-/Ba2/BB ratings have modest upgrade potential, but agencies are giving nothing to Brazil until pension reforms are completed.